Home Study

This section are marked HOME STUDY. You will need to review specific
videos on the online portal for these sections. Each HOME STUDY section
will clearly direct you to the appropriate video. For example:

Investment Management You can find the video for this on you online study portal:
Investment Management > Video > Chapter 9 – Types of Risk and
Chapter 9
Risk Management
Investment Management > Video > Chapter 9 – Active and Passive
Risk Management

10 questions

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Investment Management
Types of Risk and Risk Management

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Section Overview (Home study)
Risk and Reward Basics of risk and Investment Management
reward • Advantages and disadvantages of:
• Risks and rewards of investments in: - Active management
- Equity instruments - Passive management
- Money Market instruments • The role of ESG investing
- Debt instruments • The role of hedging
- Overseas investment
• Ranking in liquidation (covered in
• Risks facing investors Chapter 2)
• Optimising risk/return
- Diversification Institutional Investment Advice
• Requirements of differing institutions

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 Home Study
9.1.1 Risk and Reward Some sections are marked HOME STUDY. You will need to review
specific videos on the online portal for these sections. Each HOME
Risk and Reward STUDY section will clearly direct you to the appropriate video. For
• Risk and potential reward example:
- Positively correlated
• Low risk investments provide lower expected returns and a lower possibility of loss You can find the video for this on you online study portal:
• Higher risk investments have the potential for higher returns, and a greater possibility of loss
Risk and Reward > Video > Chapter 9 – Types of Risk and Risk
Required Return
Management
• Required return = risk free rate + risk premium
- Risk free rate? Government bond yields
- Risk premium? Additional return for takin on more risk
• More risk = Higher risk premium
Diversification
• An investment management technique to optimise the risk/reward trade-off
• Combining securities that are not perfectly positively correlated
- By asset class
- By sector
- By location, etc.

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 Home Study
9.1.1 Risk and Reward
Two general portfolio risk considerations
Hints
• Systematic risks (market risk)
Summary
- Economic, political and global events that impact on markets – hard to predict
• Liquidity – in a crisis liquidity dries up, e.g. a bank failure Total Risk
• Interest rates – impact on markets, and on consumer spending of gearing
• Inflation – erodes savings, around 3% inflation has led to lower interest rates
• Currency – will we make or lose money when we convert the foreign currency back to sterling?
Specific Systematic
• Unsystematic risks (specific risk)
Unsystematic Market
- Business risks – (internal business risks)
• Products – successful vs. unsuccessful; labour relations – strikes, disputes; costs of raw
materials; strength of balance sheet May be eliminated by Cannot be reduced by
- Industry risks – (industry sectors) diversification diversification
• Affect an industry as a whole not only a company (tariffs and trade barriers)
- Management risks Measured by beta
• Calibre of the management β
- Financial risks
• Related to the level of debt financing in the capital structure

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Keeping on Target
Which one of the following could be considered an example of an
unsystematic risk?

A. The change of a company's price relative to the market revenues less

expenses
B. A political crisis
C. The costs of goods and services changing
D. A profit warning from a single company

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9.1.1 Risk and Reward
Other Risks Investors Face
Further Information
• Inflation risk – Inflation will erode returns or purchasing power
Quantifying risk
• Interest rate risk – Changes in interest rates will affect prices
Forward-looking – based on forecasts and probabilities
• Reinvestment risk – Changes in interest rates will affect the reinvestment Backward-looking – analysing historic trends or observed returns
returns
• Default risk – An investor may find that a company from which s/he has
purchased a security could become insolvent
• Liquidity risk – During stressful periods this liquidity can diminish and it can
become much harder to sell a security readily Keeping on Target
• Exchange rate risk – Any investor who purchases securities which are The analysis of risk and return is best done in which of the following ways?
denominated in a foreign currency may suffer (or benefit) from changes in the
exchange rates A. Backward-looking analysis of historic returns and forward-looking
• Political and legal risk – Particularly relevant when investing overseas forecasts
B. Correlations of returns and capital asset pricing model
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C. Alpha and beta analysis
D. Political risks and interest rate sensitivities

Answer to the question on the previous slide = D

A specific (or unsystematic) risk is that something adverse impacts the
value of a particular investment, but the adverse impact is not market-
wide. An obvious example is a company's management making some sort
of error – perhaps producing a defective product with resultant impact on
profits and customer goodwill. Specific risk can be diversified away by
holding many investments.
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9.1.2-5 Risk/Reward Profile
Investment Risk Profiles
Links
Impact of security
High
Return

Leveraged securities

Equities

Collective investment schemes

Corporate bonds

Government bonds
Bank accounts
Low Risk

Low High

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Answer to the question on the previous slide = A

In order to assess the risk and expected returns from particular
opportunities, an investor needs to conduct an analysis of the forecasts for
the economy and the forecasts for particular companies and/or sectors
and undertake a risk analysis of the possible outcomes, and their
likelihood, which could adversely affect these forecasts. Forward-looking
forecasts and probabilities assess the likelihood of each possible state of
the world occurring and estimate the returns and values arising given that
particular outcome. Backward-looking analyses tend to study historically
observed returns and associated frequencies on the assumption that this
past data will be representative of the future.
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9.1.8 Hedging Using Derivatives
Hedging Strategies
Further Information
• Hedging strategies largely remove the price risk of an investment, but they will Future
also have an impact on the performance
A future is an agreement to buy or sell an asset on a fixed future date for a
Future Option
Contract for price agreed today.
Difference (CFD)
Option
Long underlying Short future Long put An option gives the holder the right to buy (call) or sell (put) an asset on
Short position
position (short hedge) (protective put) (or before) a fixed future date at a fixed price.
Short underlying Long future Long call The holder will pay to get these rights – a premium.
Long position
position (long hedge) (protective call)
Contracts for difference (CFD)
Impact on Can eliminate Premium reduces Can eliminate gains A CFD is a cash-settled derivative giving exposure to the returns on an
performance gains on positions performance on positions asset without ownership of the asset
CFDs are margin traded. This gives exposure to the asset at a fraction of
the price.2.29

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Keeping on Target
Hedging with the use of derivatives is a strategy that helps investors with:
A. Protecting against losses
B. Removing or reducing their upside
C. Increasing their exposure to assets
D. Taking short positions

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Investment Management
Active and Passive Risk Management

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Answer to previous Keeping on Target question: A

Derivatives can be used in many ways to achieve many different things.
When used for hedging, it is about reducing their risk to investments by
protecting the downside.
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9.1.9 Active and Passive Investment Management
The Efficient Markets Hypothesis (EMH)
• In an efficient market information about assets is freely available, has been
correctly interpreted and properly priced on the markets Links
Passive fund management - Tracking
• Passive management We met tracker funds when looking at exchange-traded funds (ETFs).
- Consistent with the idea that markets are efficient Methods of tracking
- Attempts to track rather than outperform the markets • Replication
• Active management – Buying all the shares in the benchmark with the correct weighting
- Seek out inefficiencies in the markets • Synthetic
- Attempts to outperform the markets – Buying futures that represent the benchmark

Synthetic replication may reduce costs and any possibility of tracking

error, but it exposes the investor to the risk of the derivative provider being
able to meet their obligations.
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9.1.8/9 Active and Passive Investment Management
Active vs. Passive

Advantage Disadvantage Further Information

Active Choice of investments Key person risk Smart Beta
• Exploit less efficient segments • Manager may move on
Instead of using a market index, smart beta funds will use alternative
of the markets • Manager may make bad weighting methods, such as dividends paid, sales revenue or cash flow
• Avoid specific (riskier?) choices
generated. Once the benchmark is created, it is tracked passively.
sections of the market Costs
Higher than market return

Passive Reflects the market as a whole Lack of control over individual

• Diversified portfolio investments
• Collective opinion Return equal market returns
Lower costs • Positive and negative
• No chance for alpha

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9.1.8/9 Active and Passive Investment Management
Active Bond Portfolio Management
• Anomaly switching
Hints
- Exploiting mispricing in the bond market
Easier question on bond portfolio management simply ask which is
• Policy switching passive/active
- Exploiting market shifts caused by, for example, interest rate movements
• Inter-market switch
Active Passive
- Trading on the spread between a bond and its benchmark
• Riding the yield curve Anomaly Switching Immunisation
- Buying a longer-term bond than required and selling it before maturity Policy switching Duration matching
Inter-market switch Dedication
Riding the yield curve Cash matching

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9.1.8/9 Active and Passive Investment Management
Passive Bond Portfolio Management
• Cash matched/dedicated portfolios Further Information
- Matching cash flow of bonds to the liabilities
Immunisation
• Duration matching/immunisation
Bullet immunisation – bonds with durations close to the timing of the
- Matching the duration of bonds to the liability
liability.
Barbell immunisation – bonds that have equal weightings either side of
the liability. E.g. 10 year liability met with 50% 8 year duration bonds and
50% 12 year duration bonds.
Ladder immunisation – a variety of bonds with different durations either
side of the liability. The weighted average duration will be the same as the
liability.

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Hints
Laddering is a term used to describe diversification of a bond portfolio by
maturity date.

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9.1.10 ESG Investing
Environmental, Social and Governance Factors
• Environmental, social and governance, also known as responsible investing
(RI), socially responsible investing (SRI) or sustainable investing
Hints
Summary
• Issues:
- Environment
• For example, sustainable use of natural resources, recyclability, reduction of pollution Total Risk
- Social
• For example, equal opportunities and training for employees, supporting the supply chain
through fair pay, providing opportunities in the community
- Governance
Specific Systematic
• For example, boards that are balanced in race and gender, corporate transparency where there
is environmental and social impact, accountability where it is owed Unsystematic Market
• Greenwashing:
May be eliminated by Cannot be reduced by
- Making misleading environmental claims for marketing purposes with the aim of
improving their reputation to attract environmentally and socially aware consumers, diversification diversification
employees and investors, thereby increasing profits
Measured by beta
β
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 Home Study
9.2.1 Institutional Investment Advice

Proportion of Proportion of
Investment
equity money market Risk profile
horizon
investments investments Hints
Pension fund Long-term High Low High Defined benefit pension funds and insurance companies are liability driven
investors (LDI). Liabilities can be real (affected by inflation) or nominal (a
Life assurance
Long-term High Low High pre-determined amount).
fund
General
Short-term Low High Low
insurance fund

Bank Short-term Low High Low

Investment
horizon
Strategies Risk profile Keeping on Target
Arbitrage Money market funds aim to achieve maximum returns while minimising
Hedge fund Short-term Geared High credit, market and liquidity risks. These funds typically invest in:
Long/short strategies

A. Government securities, short-term bonds, commercial paper,

Knowledge | Skills | Conduct repurchase agreements or even other money market funds
B. T-bills, medium-term bonds, commercial paper, repurchase
agreements or even stock lending agreements
C. T-bills, medium-term bonds, commercial paper, repurchase
agreements or even enterprise investment schemes
D. Government securities, long-term bonds, commercial paper,
repurchase agreements or even cross currency swaps

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Section Review
Investment Management Investment Management
• Basics of risk and reward • Advantages and disadvantages of:
• Risks and rewards of investments in: - Active management
- Equity instruments - Passive management
- Money Market instruments • The role of ESG investing
- Debt instruments • The role of hedging
- Overseas investment • Ranking in liquidation (covered in Ch2)
• Risks facing investors
• Optimising risk/return Institutional Investment Advice
- Diversification
• Requirements of differing institutions

Knowledge | Skills | Conduct

Answer from previous page: A

Money market funds are managed funds that invest in short-term, low-risk
credit securities. They aim to achieve maximum returns while minimising
credit, market and liquidity risks. They typically invest in assets such as
government securities, short-term bonds, commercial paper (CP),
repurchase agreements or even other money market funds.
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 Hints
Course Evaluations Method to pass
Preparing to pass – study methods
Following your course, you will receive an email containing an evaluation form.
• Read each chapter of the text, make notes/mind maps®
Please take the time to complete this and return it by email – your feedback is
really important to us. • Test your understanding of each chapter with practice questions
• Re-read the text – you’ll learn more every time you re-read it
• Complete all practice questions and mock exams, ideally twice (>80%)
Many thanks,
• Complete additional questions, ideally twice (>80%)
In the exam – techniques
Andy Bennett • Remember the hard work has already been done
• Read the questions carefully
Head of Regulatory Exam Training
• Rule out wrong answers
• Come back to more difficult questions later on
• If you’ve read the question correctly, your first thought is generally the
right answer
• Be wary of changing answers
Knowledge | Skills | Conduct • You can do it – believe in yourself
• Enjoy your celebrations when you pass

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